What is cash flow?
What is cash flow and why is it important? Looking for a simple cash flow definition? We’ve got you covered.
What is cash flow?
The cash flow definition is as follows: cash flow is the net amount of cash and cash-equivalents moving in and out of a business, institution or individual’s pocket. In finance, the term is used to describe the amount of cash generated or consumed in a given period of time.
At the most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows. Therefore, cash flow meaning is that of how seamlessly money flows in and out. If there are any delays or blockages, a business may simply not stay solvent.
There are many types of cash flow with various important uses for performing financial analysis and running a business.
Where have you heard about cash flow?
Cash flow makes the news when a company is facing liquidity problems that threaten its future. More positively, it may be mentioned in financial reports about businesses that have strong cash flow.
What you need to know about cash flow...
Investors study cash flow to see how robust a company would be in the event of a downturn or an unexpected drain on resources. Without a strong liquidity position (good cash flow), a business might not be able to meet its day-to-day running costs without relying on loans. Cash flow minus capital expenditure is known as free cash flow.
Cash flows can either be negative or positive. It calculated by subtracting the cash balance at the beginning of a period, also known as the opening balance, form the cash balance at the end of the period, known as the closing balance.
If the difference is positive, it means a company has more cash at the end of a given period, and vice-versa.
Positive cash flow indicates that a company's liquid assets are increasing, enabling it to reinvest in its business, pay expenses, settle debts, return money to shareholders and provide a hedge against potential financial challenges. Companies which show strong financial flexibility can take advantage of profitable investments and do better during economic downturns.
In order to analyse the cash movements, cash flow statements are prepared. These have three main categories: operating cash flow, which includes day-to-day transactions; financing cash flow, which includes transactions related to the number of dividends paid out to shareholders, and investing cash flow, which includes transactions made for expansion purposes.
Understanding the cash flow statement is essential for investors to assess the company's liquidity, flexibility and overall financial performance.
However, when making an investment decision, the level of cash flow might not be an ideal metric to analyse a company.
For example, if a company's cash level is increasing after it has sold some of its assets, that doesn’t mean that liquidity is improving. If a business had to sell some of its assets to pay off debt, it is typically seen as a negative sign that should be investigated further for more clarification.